FIN 329 Exam 3
Tax Principles
(1) The worldwide approach (residential or national approach): levies taxes on the income earned by firms that are incorporated in the host country, regardless of where the income was earned (domestically or abroad) - U.S. used to belong here until 2017; now (2) The territorial approach (source approach): focuses on the income earned WITHIN the legal jurisdiction of the host country, not the income earned outside the country - e.g. Germany, many other countries, and now U.S. BUT, as with all questions of tax, numerous conditions and exceptions exist. These are just principles. No matter what, territorial or worldwide - a problem arises when resident firms earn income outside the country.
National Markets and Asset Performance
- 1977 - 1996 (or even 1900 - 2000): equity - substantial returns S&P 500 Average Annual return: - 1928 - 2014: 11.53% - 1965 - 2014: 11.23% - 2005 - 2014: 9.37% - contiguous markets - higher correlation coefficients - capital markets around the world - more and more integrated over time: a lot more capital flows across borders; more investors diversify globally - truly 'global financial markets'
Strategic Management of Operating Exposure
- Changes, especially unexpected changes in FX rate - future cash flows - to manage this, management can diversify the firm's operating and financing base. - MNEs by definition are doing this or in a much better position to diversify compared to purely domestic, as their operations are multi-national; domestic firms of course are exposed to FX risk. - Internationally diversified CFs - reduce overall risks/ volatility of CFs; increased availability of capital - lower cost of capital; multi-national businesses - 'a good thing' if managed well - enlarging the opportunity set.
Tax basics
- Direct tax - applied directly to income source (individual & corporate income, property); - Indirect tax - some other measurable performance, e.g. transaction (no universal definition, but sales tax or value added tax is a good example) Some other tax terms: - income tax: corporate/individual (US - used to have the highest corporate income tax rate until 2017) - withholding tax: passive income (dividend, interest, royalties) are usually (supposed to be) withheld if earned in a foreign jurisdiction to prevent tax evasion - major part of bilateral tax treaty. - value-added tax: most common - sales tax; major source of tax revenue in many countries, usually production goods (plant, equipment) and often certain necessities (medicine, health related) are exempt. - Other national taxes: (vary a lot across countries) financial transaction tax, property tax, inheritance tax, transfer tax, ... etc etc etc ... with of course many exceptions and special circumstances ...
Hedge
- MNEs possess a multitude of cash flows that are sensitive to changes in 1) exchange rates, 2) interest rates, 3) commodity prices; 4) other prices; 5) macro-variables, etc. Hedging - position-taking on cash flow, asset, or contract (forwards, futures, swaps) - rise (fall) in position value to offset a fall (rise) in the value of an existing position. Hedging narrows the distribution (variance) of cash flows, asset prices etc. around the mean. Hedging - prevent/minimize loss; but also eliminates/reduce gain (hedging is not free). The value of the firm, according to financial theory, is the net present value of all expected future cash flows. The fact that these cash flows are expected emphasizes that nothing about the future is certain. Currency risk is defined roughly as the variance in expected cash flows arising from unexpected exchange rate changes. A firm that hedges these exposures reduces some of the variance in the value of its future expected cash flows.
Other Tax Related Issues
- To prevent double taxation on the same income, most countries grant a foreign tax credit for income taxes paid to the host country. - Tax credit - direct reduction of taxes; deductible expense - reduce taxable income before the tax rate is applied. - If there were no credits for foreign paid, sequential taxation by the host government and then by the home government would result in a very high cumulative tax rate. - Foreign affiliates of an MNC can transfer cash to the parent company through dividends, royalties, management fees, and the sale/purchase of goods/services; the sale/purchase prices of goods/services - "transfer pricing" - Dividends (a bulk of international cash flows to parent co's; paid from after-tax profits - can be thought of as 'pulling the money out' of the host country); royalties/management fees/franchise fees/overhead costs - deducted from taxable income (can be viewed as legit expenses) - MNCs are faced with political risk: any actions could attract regulatory scrutiny from host gov't/tax authorities, etc.
Back-to-back loans
- a back-to-back (parallel loan, credit swap) occurs when two business firms in separate countries arrange to borrow each other's currency for a specific period of time. - Each firm borrows the same currency it repays - different from traditional swap deal in that swap banks are not involved and transactions occur outside the FX markets. Two fundamental impediments: 1. difficult for a firm to find a counterparty for the desired currency amount and timing. 2. Counterparty risk - rather large, even though potential loss is covered by 100% collateral or 'right to offset' - currency swap so popular Process: 1. British firms wishes to invest funds in its Dutch subsidiary 2. British firm identifies a Dutch firm wishing to invest funds in its British subsidiary. 3. British firm loans British pounds directly to the Dutch firm's British subsidiary 4. British firm's Dutch subsidiary is loaned euros from the Dutch parent - The back-to-back loan provides a method for parent-subsidiary cross-border financing without incurring direct currency exposure.
Matching currency cash flows
- acquire debt in Canadian $ - interest and principal payments - matched with cash inflows (sales); (the basic concept is the same as in transaction exposure management) - Seek out potential suppliers of raw materials, components in Canada instead of in U.S. (A/R-A/P match) - currency switching: pay foreign suppliers (e.g. from Mexico) with Canadian $; Mexican suppliers might like to receive in Canadian $.
Currency clauses: risk sharing
- contractual agreement in which the buyer and seller agree to "share" or split currency movement impacts on payments between them. - intended to smooth the impact of volatile and unpredictable FX rate movements.
Corporate Inversion
- important ways of MNCs reducing taxes: - corporate inversion = changing the company's country of incoporation/legal domicile to a low tax jurisdiction : Although the company's operations may be completely unchanged, the company will now have a new corporate home, and its old country of incorporation will now be only one of many countries in which the firm operates foreign subsidiaries. among many: - 2015 announced 'Pfizer - Allergan' (Ireland Pharma co.) merger deal; later pulled off due to "NEW" regulation; - 2002 'Stanley Works' (Stanley Black & Decker) attempted to do a corporate inversion to Bermuda; it was legally acceptable, but public & political pressure stopped it. - but there are of course successful ones (Tyco International - Bermuda 1997); if not inversion, MNCs can use 'similar' methods to reduce their taxes. - regulations/laws can only do so much...
Ganado Example: Free Cash Flow
=EBIT(1-Tc) + depreciation - capital expenditure - (DELTA)NWC = CFFA (CF from Assets) - "review" The idea: "We want to figure our cash flow that matters (free cash flow) to figure out our operating exposure!" - Case 1: forecast based on no change in any variable ('base case' for comparison purpose) - Case 2: unit sales price EUR12.8 remains the same (i.e. $ price decreases to $12.8 from $15.36) - unit sales increase - 1.4 million units (from 1 million) - FCF actually goes down in 1st year; after that FCF increases - Case 3: units sales price increase: EUR12.8 - EUR15.36 (=$price, $15.36, remains the same) - unit sales do not change; FCF in 1st year larger than case 2. - Case 4: unit sales to 1.1 mil, unit sales price EUR14.08; unit direct cost EUR10.00 - more "realistic" than case 1, 2. Case 2 - initial investment in NWC LARGE as the unit sales is the highest, 1.4 mill - tie up cash in A/R and INV - 1st year FCF goes down. Case 2 and 3 - two "endpoint" scenarios; in the real business world, most likely scenarios will fall somewhere between case 2 and 3, case 4 is one such scenario. The event = euro value decline - can affect futue cash flows differently depending on different scenarios - different operating exposure - different risk management/ hedging strategies. - Similarly, you can analyze/forecast different scenarios regarding how EUR value will change relative to $ to plan hedging for the future - operating exposure (We do one year FCF here; in practice, one needs to estimate all the future FCFs - multi-year or infinite time horizon - then discount those with the discount rate to get to the PV - value of the firm, Ganado Germany)
Money Market Hedge
A money market hedge (money mkt - short-term financial market; 'balance sheet hedge'): borrows in one currency and exchanges the proceeds for another currency. - Funds to fulfill the contract - available = 'covered' - Such funds - not available now - 'uncovered or open' - Ganado (GBP 1 million A/R) - (covered) money market hedge - borrow in pound to repay interest and principal GBP 1 mil in 3 months
Calculation of portfolio risk and return - two asset case
Asset 1: Expected Return = 14%, expected risk (st. dev.)= 15% Asset 2: Expected Return = 18%, expected risk (st. dev.) = 20% Correlation Coefficient = .34 Portfolio return = .164 Portfolio st. dev. = .151
Internationalizing the Domestic Portfolio
Classic portfolio theory assumes a typical investor is risk averse. Will not assume risk, if not properly compensated for such risk The typical investor - maximizes expected portfolio return given a level of expected portfolio risk, (or minimize risk, given a level of expected return).
CFC & Subpart F Income
Controlled Foreign Corporation (CFC): a foreign corp. that is more-than-50% owned by US shareholders/US Corp/US parent; many US residents used to avoid tax through CFCs. Subpart F income (1962) rules: designed to prevent US residents from deferring/avoiding tax through use of CFCs; Subpart F income - subject to immediate U.S. taxation even if NOT remitted to US; ((complicated provisions as with many other tax rules; by and large - applies to 'passive income'; before Subpart F income rules were created in the 60s, US residents did not pay taxes on foreign source income until it was remitted to US)) But again, regulations/laws can only do so much (exceptions, caveats, loopholes; e.g. 'check the box' in minicase) - mini-case: Apple's Global iTax Strategy
Optimal Portfolio Construction
Domestic portfolio: Use the efficient frontier and the capital market line to identify the tangency point known as the optimal risk portfolio. All investors are on the capital market line, with differing levels of risk aversion, therefore being closer or farther from the optimal risk portfolio. Internationally diversified opportunity set: International diversification expands the opportunity set outwards and allows for higher returns for equivalent levels of risk due to a higher efficient frontier. Again, find the tangency point to find the optimal risky international portfolio and adjust your standing on the capital market line for risk aversion.
Managing Operating Exposure
Ex: a US firm has continuing export sales to Canada; the firm invoices all export sales in Canadian dollars; this policy results in a continuing receipt of Canadian dollars month after month (series of future transactions). - This endless series of transaction exposures could be continually hedged with forwards or other contractual agreements. But there are alternatives. Some commonly employed proactive policies are: - Matching currency cash flows - Risk-sharing agreements - Back-to-back or parallel loans - Currency swaps
International Diversification
Exactly why international diversification is adding value? - gains from adding additional assets that are of less than perfect correlation with the assets in purely domestic portfolio. - asset returns are not perfectly positively correlated - risk reduction, because fluctuations of asset returns will offset each other. - different stock markets around the world -- not perfectly positively correlated (different industrial structures, different economies, different business cycles, etc.)
Risk Management in Practice
Firms must decide which exposures to hedge: - An increasing number of firms are actively hedging ANTICIPATED exposure. (They should) - Anticipated exposures are transactions for which there are - at present - no contracts or agreements between parties. - In a sense, there are two groups of hedgers: 1) those that use options; and 2) those that do not. - Option premium - upfront explicit cost; can be very expensive; in recent years, volatility went up (different from margin req'ts in futures) - Firms that do not use currency options - forward contracts and money markets hedges. - These firms often set a percentage of existing transaction exposures that need to be hedged.
Foreign Exchange (Risk) Exposure
Foreign exchange (risk) exposure or currency (risk) exposure: as FX rates or currency values change - asset value/cash flow value changes - Types of FX exposure: 1) Transaction exposure - FX risk specific to (committed) transactions/ contracts/ outstanding financial obligations 2) Operating exposure - FX risk that affects future (uncommitted) operating cash flows 3) Translation exposure - accounting exposure: accounting-derived risk; doesn't necessarily have to have any value implications - One risk exposure does not need to exclude the other (not mutually exclusive); different textbooks carry slightly different definitions. - Transaction exposure + operating exposure + other with value consequences = (can be collectively called) economic exposure: FX risk that affects the value of the firm (A=D+E: PV of future cash flows) - Also, there is a tax issue (tax exposure) - countries tax differently.
Forward Hedge
Forward hedge - buy or sell forward contract (futures hedge - the same in essence) - funds to fulfill the contract not already available or due to be obtained later - "open" or "uncovered" hedge - thus, there is risk (the purchase of such funds at a later date is referred to as "covering") - such funds available now - "covered" hedge - Ganado forward hedge - (covered) hedge - sell pound 3-mo forward at $1.7540/GBP
Ganado Germany Example
Ganado Germany (Ganado = US based MNC) uses European materials and labor; sales etc. invoiced in euro; products sold/exported to all over the world ($ zone) - of course, currency risk exposure (this chapter - zoom in operating exposure); operating exposure is far more comprehensive and complicated than transaction specific exposure. Assumptions: - Unit price: EUR12.8 (=$15.36: exch rate at $1.2/EUR) - A/R - 25% of sales (receivable turnover = 4: avg collection period/receivable period = 90 days) - A/P = EUR800,000 - fixed - Cash operating exposure (SG&A) = EUR890,000/yr - fixed - Depreciation = EUR600,000/yr - fixed - Capital expenditure = 0 - fixed - Corporate tax rate in Germany = 30% Event: unexpected drop in Euro: $1.2000/EUR to $1.0000/EUR
Ex: Ganado's (US Firm) Transaction Exposure
Ganado's Transaction Exposure: sold equipment at (Pound-Sterling)1 million (sold March; payment June - A/R); CFO, Maria Gonzalez, has four alternatives ("what is she afraid of?") Gonzalez is afraid of drop in Pound-Sterling value - Remain unhedged; - hedge in the forward market; - hedge in the money market (balance sheet hedge); - hedge in the options market
Google: An Illustrative Case of Profit Repositioning
Google's offshore tax strategy, dubbed 'Double-Irish-Dutch-Sandwich' - is based on 1) re-positioning the ownership of much of its intellectual property to a subsidiary in a low-tax environment; 2) then establishing high transfer prices on various forms of the profits in the near-zero tax environment of Bermuda. They do so 'legally' often sanctioned by IRS (PE rule); - IRS cannot catch up; certainty of some tax revenues are better than searching and imposing taxes (incurring serious costs) It is estimated that 75% of the top 50 U.S. software, internet, and computer hardware companies use similar structures that help them avoid taxes. Google's effective overseas tax rate: 2.4%
Currency Swaps
In a currency swap, a firm and a swap dealer or swap bank agree to exchange an equivalent amount of two different currencies for a specified amount of time. Swap banks/dealers pool many customers around the world, thus reducing counterparty risk. Introduced on a global scale in the early 80's - it became one of the largest derivative markets in the world. (U.S. acctg) A currency swap resembles a back-to-back loan except that it does not appear on a firm's balance sheet; treated like forwards
Multinational Tax Management
MNE Tax planning - extremely complex but vitally important. Ex) GE - present in about 170 countries - 1) worldwide operations - complicated; - 2) different structures/interpretations of tax liabilities across countries - complicated The primary objective - minimization of the firm's worldwide tax burden.
Tax-haven/Int'l Offshore Financial Centers
Many MNEs tax-haven subsidiaries or 'international offshore financial centers' - a result of different tax provisions across countries. Tax-haven subsidiaries - established in a country that can meet the following requirements: - a low tax rate on foreign investment or sales income earned by resident corporations and low dividend withholding tax and dividends paid to the parent firm. - a stable currency to permit easy conversion of funds into and out of the local currency. - The facilities to support financial services activity - A stable government that encourages the establishment of foreign-owned financial and service facilities within its borders
International Diversification and Risk
Now international portfolio - international diversification of portfolios, more assets - further room for diversification - a good thing! - risk reduction benefit. - currency risk/FX risk does complicate risk profile of the portfolio. It has to be managed well (hedging issue). - But, the currency risks/FX rate risks of a portfolio are ALSO reduced through international diversification! International Diversification Benefits: 1) reduction of risk for a given level of return; or increase in the expected return for a given level of risk (standard portfolio theory argument) 2) risk-reduction - discount rate goes down, i.e. lowering the cost of capital 3) reduced discount rate/cost of capital - asset price goes up (other things being equal, of course) International diversification lowers the level of systematic risk and expands the opportunity set and efficient frontier
Taxes and Transfer Pricing
One of the most important motivations - TAX!!! - Thus, US IRS regulates transfer pricing: Section 482 of IRS code: IRS can re-allocate gross income, deductions, credits, or allowances between related corporations (i.e. transfer pricing) in order to reflect more clearly a proper allocation of income. - pretty strong regulatory power - burden of proof is on the firm, NOT IRS ('guilty until proven innocent') 'correct price' - arm's length price ('objective' price): price charged for the same product sold to a comparable unrelated customer. Again and again, it is really not the lack of IRS codes and related regulations that many MNEs pay low effective tax rates. There exist many loopholes and exceptions through which tax lawyers and accountants work the system.
Option hedging
Option hedging - an upside potential + limiting downside risk; it comes with a cost, option premium. - The choice of option strike prices affects option premiums & payoff patterns - Ganado: purchased three month put option at strike price = $1.75/GBP
Pfizer-Allergan Merger Deal
Pfizer, Allergan agreed to a historic merger; announced $150b deal in Nov, 2015: - The largest "inversion" ever: corporate (tax) inversion = practice of relocating a corporation's legal domicile to a lower-tax nation, or tax-haven, usually while retaining its material operations in its higher-tax country of origin. - The merged firm's tax domicile will be Dublin, Ireland - It is estimated that Pfizer's tax rate is 25%, the highest among its big pharma peers - the merger would lower Pfizer's tax below 20%; Allergan has roughly 15% tax rate (estimated) - Again the question: lowered corporate tax rate 21%: what will this do here? - Existing rules could not prevent such an inversion; - In April 2016, however, the Treasury dept. came up with the "new" rules; IMMEDIATELY following this Treasury announcement, the merger deal was called off!
Why hedge?
Proponents of hedging cite: - Reduction in risk in future cash flows improves planning capability of the firm. - Reduction of risk in future cash flows reduces the likelihood that the firm's cash flows will fall below a necessary minimum (the point of financial distress) But it comes with costs: options premium, loss of upside potential, and other transaction costs, etc. - weigh benefits against cost to hedge or not
Cash Abroad (Summary of articles)
Significant amount of profit or cash for US multinationals is held ABROAD - as of 2nd quarter of 2017: 24 largest US firms hold $1.01 trillion cash -> about 80% -- held abroad (yahoo finance/business insider) - as of 2015, parked abroad = $2.3 trillion cumulative earnings by S&P 500 companies including Apple, Google, Microsoft, Pfizer, etc. (bigger GDP than Italy - more than 40% of them estimated to be in cash! - The amounts differ across different firms with different reasons; but they are significant for sure. - Some (esp. high-tech/pharma/bio-tech) shifted intellectual properties (patents, rights, ...) offshore to avoid tax. - Tax holiday (2005) - spike in cash inflow, but no evidence it created jobs (global fin prac 1) Why so much abroad? 1) High corporate tax rate in US up until 2017 2) Substantial revenues/opportunities exist overseas; cash needs to be parked there for future investment/growth potential. US corporate tax - the highest in the world until 2017 - It used to adopt 'worldwide approach' (as opposed to 'territorial approach') - roughly speaking, earnings are taxable whether or not they accrue in US or abroad. - Yet, if cash/earnings are declared 'permanently reinvested in foreign countries (PRF),' then it is not taxable or the tax is deferred (e.g. MSFT $108.3 bill earnings (Jun '15); AAPL $91.5 billion cash (Sep '15)) Strange Phenomena: (1) a bunch of cash held abroad; yet they have to borrow in US to pay dividends, buy back shares etc. (e.g. Apple) - inefficient capital structure. (2) often, this cash still resides in US; the cash accounts held by foreign units typically purchase US treasuries, US corporate bonds, etc - a) these are safe assets; b) by holding US assets, they avoid currency risks! - As of 2018, it adopts the 'territorial approach' - Questions: lowered corporate rate will do what to these multinationals? Will they repatriate how much? Will they create jobs?
Hedging Operating Exposure with Options
Some MNEs - hedge their operating exposure with options. - (Example) Merck and Eastman Kodak - purchased long-term OTC currency put option on foreign currencies; - to offset lost earnings from a decrease in foreign currency value - such long-term option premium can be pricey; again, hedging is costly. - predictability of cash flows will affect forecasting ability of MNEs.
Tax Treaties
That is why there is a network of bilateral tax treaties; Many of them - modeled after the one proposed by OECD (Org. for Economic Cooperation and Development); the idea is to reduce double taxation and tax evasion. Tax treaties - bilateral; two parties agree on if, when, how, what tax rates are applicable to which types of income between themselves alone. This can be complicated as two nations differ in tax treatment, tax laws etc.
Tax Cuts and Jobs Act of 2017
The U.S. Congress rammed through Senate & House the Tax Cuts and Jobs Act of 2017 ("tax bill"; signed by President Dec. 22, 2017) Barring (complicated) details of $1.5 trillion tax bill: - corporate tax rate: 21% permanent; - individual income tax rates = temporarily lowered but expire after 2025; - repealed individual mandate of the Affordable Care Act. - American Enterprise Institute, Brookings Institute, Tax Policy Center, and Institute on Taxation and Economic Policy (ITEP) are in general skeptical or against bill; - both right-leaning and left-leaning organizations: - tax cuts largely tilted toward "the very top 1%" - Trickle Down? ITEP: studied Fortune 500 companies that are consistently profitable for 2008-2015: - 258 firms paid an effective federal income tax rate of 21.2 (slightly over half the statutory 35 percent tax rate); - 18 firms (GE, International Paper, Priceline.com, PG&E) paid NO federal income tax at all; - 48 firms (about 1/5 of all) paid an effective tax rate of of less than 10% In short, without addressing loopholes, exceptions, and tax shelters, there cannot be a tax "reform"
Sharpe and Treynor Measures (reward-to-risk ratio: Performance Measure Adjusted for Risk)
To consider both risk and return in evaluating portfolio performance, we introduce two measures: Sharpe Measure (SHP) = (Ri - Rf)/(st. dev.) Treynor Measure (TRN) = (Ri - Rf)/Betai
Total Risk of any Portfolio
Total risk of any portfolio = systematic risk (market/un-diversifiable risk) + unsystematic risk (individual asset risk/idiosyncratic risk/diversifiable risk/firm-specific risk) increasing # of assets/securities - reduces unsystematic risk component called 'diversifiable risk' (a CEO resignation, labor dispute in a firm) systematic risk - not diversifiable by forming a portfolio; affected by market-wide sets of factors (inflation, interest rate changes, GDP, recession, etc.) - Measured in beta
Operating Exposure
Transaction exposure - FX risk specific to 'committed' transactions/ contracts/ outstanding financial obligations Operating exposure - FX risk that affects future (uncommitted) operating cash flows - requires forecasting the firm's future transaction exposures + future exposures of the competitors. (Transaction exposure + operating exposure + other exposure with value consequences = economic exposure: FX risk that affects value of the firm (PV of Future Cash Flows) - slightly different from the textbook; definitions vary across different sources) - 3 conceptual categories: 1) transaction exposure; 2) operating exposure; 3) translation exposure (tax exposure included).
Measurement of Transaction Exposure
Transaction exposure - gains or losses on existing financial obligations in a foreign currency. - Often occurs: contract - outstanding now, but contract-based cash flows occur in the future; now and the future - currency value changes. Ex) most common: A/R (receivable); A/P (payable) denominated in foreign currency. Ex) borrowing/lending in foreign currency Ex) forward contract itself has transaction exposure; if used to hedge existing contract, two transaction exposures are intended to offset each other (hedging; transaction exposure/ risk management)
Diversification and Risk
What is diversification? (review) As an investor increases the number of assets in a portfolio, the portfolio's risk declines rapidly at first, then asymptotically approaches the level of systematic risk of the market Total risk = unsystematic risk + systematic risk
Transfer Pricing
pricing of goods/services transferred between a foreign subsidiary and a parent company or other affiliated companies: - each unit all over the world - buy & sell goods/raw materials etc. among each other : how prices (transfer prices) are charged on these - move funds in and out of a particular country; Ex) a parent company wishing to transfer funds out of a foreign country - charge higher prices on goods sold to its subsidiary in that foreign country (to the degree that government regulations allow). Ex) conversely, a parent - finance a foreign subsidiary, by lowering the transfer prices. - This problem is particularly sensitive for MNEs - legal/regulatory issue.
